Fannie Mae and Freddie Mac: Too big not to fail

Sorry to be a little late to the party on the Fannie/Freddie debacle; I managed to burn my right middle finger rather spectacularly last night on a pot handle, and though JP Freire, the American Spectator's MacGyver-like managing editor, rapidly sped to the rescue with a silicone oven mitt full of ice, typing is still somewhat slow.

Back to Fannie and Freddie. For those who haven't been following along at home, last night, in another "Sunday Save", the Fed and Treasury announced that they stand ready to bail them out. For years, there's been a moderately lively debate over whether Fannie and Freddie's status as Government Sponsored Entities (GSEs) means that the government has implicitly guaranteed their portfolios. Those who have wasted hours arguing this burning question in the nation's bars and debating clubs can settle up your bets and argue no more: it does indeed. As Clive Crook says:

US taxpayers are about to find out what their long-standing and (strictly speaking) non-existent guarantee of Fannie Mae and Freddie Mac will cost them. One way to think of it is this: take the US national debt of roughly $9,000bn and add $5,000bn. Not bad for an obligation still officially denied.

Fannie and Freddie should have been fully privatized years ago, so that they were subject to market competition; alternatively, although less ideally, they should have been brought back into the government to be regulated more effectively. Leach was right that leaving them as they were was a disaster waiting to happen. And now it looms larger than ever, with potential disastrous implications . . . Want a worst case scenario? The government takes over Fannie and Freddie. The immense increase in the national debt causes the bond rating agencies to cut their rating of Treasury securities from their traditional AAA. Along with other economic problems (whether its mostly whining or not), this spooks investors, especially foreign investors. Foreigners abandon the dollar for the euro, dumping treasuries. The collapse of foreign investment in Treasuries makes our massive current account deficit unsustainable. At which point, things really go to pot.

All because our leaders in Washington failed on a bipartisan basis to address the problems at Fannie and Freddie. Why didn;t they do something? Because Fannie and Freddie bribed them and because they’re petrified of being painted as anti-consumer, as even the Times finally noticed . . .

1. For some reason, I am reminded of a Vaudeville scene in which firemen are squirting hoses at the set to try to put out an apparent fire, and management comes out on stage to say, "Don't worry, folks. It's all part of the act." My point is that it's very important at this time for people like Treasury Secretary Paulson and Fed Chairman Bernanke to make it seem like they know what they are doing.

2. It seems as though nobody wants to admit that the FM's are done for. Yet the new proposal on the table to have the government back more of the firms' debt and perhaps buy equity is so radical that I have to assume that there is no returning to the status quo.

3. If you could do it over again from a regulatory perspective, you would want to see the FM's market shares a lot lower and the market shares of other institutions, notably banks, a lot higher. I have to assume that this will be the thrust of policy going forward. It's just not something that is going to happen tomorrow.

4. I used to work at Freddie Mac, in the late 80's and early 90's. Back then, the capital regulations gave the FM's an advantage over banks in holding low-risk mortgages. We understood that, and we stuck to low-risk lending. As times changed, and the market shifted to high-risk loans, it would have been logical for the FM's to say, "This is not our market," and allow their market shares to drop. But top management, at least at Freddie, is pretty green (I'm not sure they could spell "mortgage" when they took over in 2003. When friends of mine described the behavior of the new management team, I decided to sell my Freddie Mac stock. This was at least four years ago.). Between that and government pressure to provide "affordable housing," the FM's decided that they needed to get on the subprime bandwagon rather than stop it.

5. A fundamental debate in economics is between central planning and the spontaneous order of the market. The collapse of the FM's, and of the housing market in general, can be viewed as a failure of central planning. Unfortunately, the dynamics are such that when central planning fails, you typically get more central planning.

In my view, the central problems with FM/FM are two:

1) Because they are government sponsored, the government let them get away with practices that would never fly in the private market. Contrary to the belief of many on the left, this is par for the course; just take a look at what's happening to state and local government pensions now that the federal government has forced them to account for their liabilities like normal pension funds do.

2) They are too big not to fail. Their mortgage portfolios cover so much of the market that any significant problems in the mortgage market will make them technically insolvent as soon as they mark their securities to market. Any attempt to clean up their portfolios, by, for example, selling off some of their underperforming securities, will move the MBS markets against them, making the problem worse.

It's not clear that bringing them fully into the government is even a second- or third- best solution; the government is not set up to be a hedge fund, nor should it be. Once the immediate crisis is over, it's time to strip their GSE status and break the companies up into less risky firms.

Of course, that's easy for me to say, sitting here on my couch in my comfy pajamas. Actually doing this is going to be a monstrous messy task.

We want to hear what you think about this article. Submit a letter to the editor or write to letters@theatlantic.com.